The Prudent Yield-Hog: Pushing The Envelope

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 |  Includes: CEL, CLMT, CMO, CNSL, CPLP, DX, ENP, FTR, MFA, NLY, NMM, OTEL, PDLI, TWO, VGR
by: Marc Gerstein

On March 1, I introduced a strategy known as the Prudent Yield Hog, which is designed to do what many income-seekers desire most but are constantly warned against: chasing the highest yields available. The key to this strategy is working from a "pre-qualified" list compiled based on a screen and ranking system designed to weed out the highest-risk situations. (See Appendix, below.)

But even within this framework, approaches can vary regarding where on the risk-reward scale they fall. The list of stocks I presented on March 1 was middle-of-the-ground by yield-hog standards. Today, I want to dial up the yield and risk as far as I feel comfortable.

The key to adjusting yield and risk with the Prudent Yield Hog is a screening rule requiring, in the mid-level (default) version of the model, that all stocks rate 60 or higher (zero is worst, 100 is best) in a rating system designed to evaluate equity income candidates. For today’s list, I’m going to drop the rank threshold to 40. Table 1 shows the list of passing stocks.

Table 1

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The average yield for this group of stocks is 10.4%, versus about 9% for the mid-risk list presented on March 1. That’s pretty impressive considering we’re still in a market era characterized by exceptionally low interest rates and yields.

Figure 1 shows how the result of a 3/31/01 – 3/2/11 backtest of the model, assuming the portfolio is rebalanced every three months.

Figure 1

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The overall portfolio percent change was plus 5.9%, equivalent to an annualized gain of about 0.6%. Sample checking portfolio yields at various points in time and considering the gain-and-loss patterns at the various times, suggests a back-of-the-envelope estimate of annual total return in the 11%-12% neighborhood (subject, again, to epoch crises such as what happened in 2008).

That’s pretty good, but interestingly, not as good as the mid-teens returns the suggested by the backtest of the mid-risk version presented on March 1.

There are two ways to respond to this. One is the basic guru answer: Getting too carried away with yield reduces the capital gain/loss component of return to the point where it’s often not the optimal way to go. The other, more human, answer is that no matter what the mathematicians and textbooks say, yield and capital gain/loss are two very different things and there are reasons why many will have a distinct preference for yield. Dividends are money that is actually received; as long as we can assess companies well enough to avoid cuts, we know the return will be there. And, of course, we may choose to boost returns further by re-investing dividends. Capital gains/losses, on the other hand, are just expectations, and as such, much more tenuous.

Looking at Table 1, we now see five mortgage REITs, more clustered toward the top of the yield scale. We also see the usual suspects in today’s world of high-yield equity investing: small communications companies, shipping companies, and energy distribution firms. Anyway, these are the kinds of business yield hogs (prudent and otherwise, the differences involving company risk) should expect to be seeing nowadays, in contrast to the electric utilities that dominated the scene when I started in this business. Many might want to see property-owning REITs, but that’s probably not likely until real estate and financial market condition change sufficiently to boost yields (on REITs not subject to substantial risk of a cut) well above current levels.

We also see an interesting oddball in PDL BioPharma (NASDAQ:PDLI), a company that spun off its product operations and now exists as an entity to collect royalties and license fees relating to its antibody humanization patents. The company had occasionally paid special dividends, but early this year switched to a regular quarterly dividend which at results in a double-digit yield given the current price of the stock.

In subsequent Seeking Alpha articles, I’ll look more closely at some individual names.

APPENDIX

The Prudent Yield Hog model is based on the notion that income-seekers can achieve satisfactory returns by reaching for the highest possible yields if they work with a list that has been pre-qualified to eliminate companies that bear the greatest risk of dividend cut or elimination.

It uses a screen that contains the following rules:

Basic Universe Definitions:

  • Eliminate OTC stocks, stocks trading below $5, stocks with market capitalization below $250 million, ADRs and companies classified as Miscellaneous Financial Services (most of which are closed-end mutual funds).
  • Daily volume over the past 60 days must have averaged at least 50,000 shares.

Yield must be equal to or greater than 2/3 of the rate on the 10-year Treasury

Yield may not exceed 5 times the rate on the 10-year Treasury

The stock must rate 60 or better (zero is worst, 100 is best) under a ranking system designed to evaluate high-yielding income stocks

Here’s a summary of the ranking system referred to in the last screening rule:

Growth Profile (one third of the score)

  • Dividend growth (60% of sub-category)
  • EPS growth (30%)
  • Sales growth (10%)

Dividend Security (one third of the score)

  • Trailing 12 month dividend payout ratio (lower is better) sorted relative to industry peers

Investor Sentiment (one third of the score)

  • Price signals (30% of sub-category)
  • Technical Signals (30%)
  • Investor Comfort (40%)

To see for further detail, click here.

From the list of passing companies (i.e., those that have been successfully pre-qualified), select the 15 highest-yielding stocks.

Figure A-1 shows backtested price performance of the strategy from 3/31/01 – 2/28/11 assuming the model is re-run and the list refreshed every three months.

Figure A-1

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That’s price performance only. The model faltered during the financial crisis of 2008, as did most other strategies. But the overall start-to-finish capital gain was 106.7%; or 7.6% annualized, which would be added to the yield, which was often in the neighborhood of 9%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I may initiate positions based on the Prudent Yield Hog approach, but not necessarily within the next 72 hours. when I do so, I will run the model again and use stocks appearing in the list at tjhat time, some of which may have been referenced in this article.